Sunday, January 30, 2005

"Unlike a private trust fund, which can invest in anything, the money in the Social Security trust fund must be invested only in government securities.....By law, the government is required to repay Social Security all it has borrowed. In practice, the government for several years has been spending way beyond its means and running up huge deficits. That means the government will have a hard time finding money to repay Social Security when the loans come due."

"Many experts have speculated that Bush will favor a plan modeled on one of the options presented to him by an advisory commission he set up in 2001.
That plan would allow workers to divert up to $1,000 annually from their Social Security taxes into accounts that can be invested in the stock and bond markets. The accounts probably would be overseen by the government and administered by a private firm."

" What other fixes are possible?
A: Experts say some of these ideas are likely to come up:
- Raising the retirement age.
- Reducing benefits by using a new formula to calculate them.
- Reducing benefits for people with high incomes.
- Raising Social Security taxes beyond the 6.2 percent that workers and employers each pay.
- Raising the income cap on Social Security taxes (workers now pay taxes only up to a certain income level because they get no extra retirement benefit above it).
- Raising other taxes to help finance Social Security. "

Friday, January 28, 2005

The SportsEconomist (with a team of writers now joining Skip in putting out a vastly increased number of posts) has an interesting article reminding us that banks get paid before shareholders. What is interesting is some of the consequences. For instance, the article looks are troubled farms where the farmers are not making any money, but the banks are getting paid. The reason for the article is a discussion of how banks are pressuring some NHL owners to settle the lockout.

The Financial Accounting Blog comments on whether the growing conservatism of auditors in the wake of the Andersen debacle is too much of a good thing: "practitioners are hesitant to be more aggressive because accounting maneuvers are being increasingly scrutinized by regulators, lawyers and even the media." How is this coming into play? One example is that restatements are up. But as Dennis points out, this may be caused by this increased conservatism:

"Some of the restatements may simply reflect the fact that auditors are much more conservative and more apt to instruct a client to restate earnings after finding an error that several years ago might have been overlooked or ignored."

Brad DeLong suggests that Chile's privatized pension system is not necessarily living up to expectations. Without having seen any other numbers than those from his post and the NY Times Article on which he comments, I would only answer: is our current social security system any better? It too has problems. Indeed any system we adopt will have problems. Is the current social security system in trouble? yes. Is in awful trouble? Maybe not. But that does not mean we can't improve it and allowing some equity is probably a good thing.

And in case you ever wondered why the nickname of Economics as the Dismal Science has stuck around, check out some of the links off of the Marginal Revolution's piece on a supposed real estate bubble. Short version: US interest rates are artifically low given twin deficits and have to rise. The rising interest rates will cause real estate (and equity) prices to fall and economy will suffer. Or so goes the theory. Malthus would be so proud. ;)

Speaking at the World Economic Conference in Davos, New York Stock Exchange Chief Executive Officer John Thain confirmed that the NYSE is considering opening 2 hours earlier (at 7:30) in an attempt to capture more European business. (also CNN where Thain states this is not anything new.)

It will be interesting to watch the response of those who work at the NYSE who will most likely be asked to work two more hours.

"...the first big test of earlier trading will be whether Mr Thain can win support for the idea among traders, specialists and NYSE member companies. He says a decision is likely within a year. How soon that decision comes - if indeed it does - will be an important indicator of how seriously London and other European exchanges should take the NYSE offensive."

NPR also has an interesting angle on this is by briefly examining what it will mean elsewhere. For instance, currently many finance professionals around the globe (and especially in the US) tailor their work day around the NYSE open even when they themselves are in different time zones. Will this mean more early mornings? UGH.

Interestingly (and less widely reported), Thalen also discussed plans to increase the value of the NYSE whose seats have fallen sharply in value due at least in part from growing competition. One strategy? A public stock offering.

"A public offering would give Thain the currency needed to buy another market, according to exchange members. Thain and Securities and Exchange Commission Chairman William Donaldson, himself a former NYSE chairman, have said they expect consolidation among U.S. exchanges"

Showing why there is a great temptation to do so, the same Arizona Republic article points out the success of the Chicago Mercantile Exchange since they have gone public:

"The Chicago Mercantile Exchange, the largest U.S. futures market, sold shares in December 2002 for $35. They rose $12.80, to $209.90 in NYSE trading Thursday, giving it a market capitalization of almost $7.2 billion. The value of the NYSE's combined memberships is $1.6 billion"

The success of the Chicago market is partially behind the plans for the NYSE to trade more types of securities.

"Thain said the United States would remain the focus of the exchange's expansion for the coming year as it examines ways to expand its product line to include trading in options, futures, derivatives, convertible bonds and fixed income products, putting it head-to-head with Chicago's derivatives exchanges."

Thursday, January 27, 2005

A student pointed out today in class the usefulness of Excel Smartags. I had never used them before and was quite impressed.

What are smart tags? From the Microsoft Excel Help file:

"You can save time by using smart tags to perform actions in Microsoft Excel that you'd usually open other programs to perform"

For instance, if you have a spreadsheet that computes market capitalization of a group of firms, this can be automatically updated with current share prices and current shares outstanding.

How do you do this? From the pull down menus, go to Tools, autocorrect options, smart tags.

A quick internet search shows that these smart tags have created some enemies since Micorosoft chooses the web site (MSN in this case) they send you to for the data and may even be able to track your usage, but that said, the tags sure are useful! and you can turn them off easily enough.

Wednesday, January 26, 2005

"Want to know who are the most productive finance academics over the
past half-century? The facts can be found in a forthcoming paper in
the new Journal of Finance Literature (JFL). See the rankings of the
most frequent contributors to 72 finance journals over the past 50
years - broken down by top-tier journals, the core-sixteen journals
and all 72 finance journals.

Would you like to rapidly, and easily search the table of contents of
every finance journal ever published over the past 50 years. You can
only do that by subscribing to the new Journal of Finance Literature -
an online searchable database of nearly 50,000 finance journal
references. And access is free to JFL subscribers.
Go to financejournals.com and sample the database.

Access is open to all for the next two weeks so you can see the
benefits of being a Journal of Finance Literature subscriber.
And you surely don’t want to miss out on your copy of the Finance
Literature Index (reference of every finance article ever published in
alphabetical order by author). Only available to subscribers.
Hurry! The inaugural issue is going to press now and will be in the
mail next month.....

Alexander, Cici, and Gibson provide some interesting evidence that mutual fund managers may be better at picking stocks than previous literature has suggested. The authors show that when mutual fund trades are broken down by the motivation for the trade (for example liquidity driven, tax-loss driven, or for valuation reasons), fund managers do earn abnormally positive returns when trading for valuation reasons.

In the words of the authors:

"We argue that a fund manager who believes that a stock is significantly mispriced will want to trade in its shares. However, heavy investor outflows (inflows) will constrain the manager by forcing him or her to control liquidity by selling (buying) stocks. Accordingly, we condition fund trades on the direction and magnitude of investor flows."

"The hypothesis that fund managers possess the ability to value stocks finds strong support. Valuation-motivated buys (i.e., large buys concurrent with heavy outflows) outperformed their benchmarks by an average 7.95% in the following year whereas
valuation-motivated sales (i.e., large sales concurrent with heavy inflows) underperformed by an average of 1.10%. The 9.05% differential between buys and sales is economically and statistically significant. Results are slightly stronger when October [the month where tax trading would occur given the October tax year end for mutual funds] sales and mandated reporting-month trades are excluded in order to remove tax motivated and window-dressing trades."

Opposed to the valuation trades, fund managers fail to do as well for liquidity driven trades:

"In sharp contrast to valuation-motivated buys, liquidity-motivated buys (i.e., small buys concurrent with heavy inflows) underperformed their benchmarks by an average 1.65% in the following year."

To further buttress the findings, the authors also investigate "buys that add currently unheld stocks to the portfolio and sales that fully terminate existing positions." The findings are again consistent with the managers ability to value stocks better than the overall market.

"We find that initiating buys outperformed their benchmarks by an average of 4.19% in the year after the trade, whereas terminating sales underperformed by an average of 1.07%. The 5.26% differential is both economically and statistically significant, providing confirming evidence that fund managers possess the ability to value stocks."

A few questions that this raises:

How are managers picking these winners and what does this ability say about market efficiency? For instance: are the returns from buys that initiate positions driven by IPOs? and if so are the losing trades rewards to the investment bankers? This would be consistent with Nimalendran, Ritter, and Zhang's recent work.

Why can the managers pick winners better than they can identify losers?

Who wins and loses in a merger? In class we analyze various stakeholder groups and try to come to a conclusion for each. It is not as simple of answer as one may think. For example: “the managers of the acquired firm lose because of the increased risk of dismissal”, but how do you measure what a merger does to a community. On one hand the community may suffer from lost jobs etc, but are the jobs lost less than would have occurred had the merger not occurred?

Garmaise and Moskowitz will definitely add to this discussion by providing evidence that bank mergers may be bad for the local community through both economically as well as socially.

In their words:

“We provide micro-level evidence that neighborhoods that experienced more bank mergers are subjected to future reduced loan provision, diminished local construction, lower prices and rents, an influx of poorer households, and higher crime in subsequent years.”

Of course, the immediate question (which the authors do answer somewhat convincingly) is whether the merger causes the problems, or forecasts the problems. Again in the words of Garmaise and Moskowitz:

“We show that these results are not likely due to reverse causation since, among other evidence, we find that while bank mergers precede future crime increases, crime does not precede bank mergers, nor are the two contemporaneously correlated.”

VERY INTERESTING! Definitely the fodder for many discussions, both in and out of class, and possibly even in the regulation of future mergers.

Saturday, January 22, 2005

Ok, first off, I have to say that slavery is awful and totally inexcusable. As an avid reader of Civil War books and many slave narratives, I am utterly amazed that anyone could have allowed it or worst yet owned slaves themselves. Indeed, it is a major black eye that we ever allowed it. (And if slavery is still around today, we all should work to stop it. )

That said, I was particularly interested when I saw the following headline "Bank admits slave trade links", I had to investigate more. What bank today would ever be tied to slavery?! Well, the story, while interesting, is more of a history lesson than a current events item.

It seems that Citizens Bank and Canal Bank (two Louisiana-based banks), accepted slaves as collateral from 1830-1865 (many banks did as slavery was legal and these people were seen as property). The banks were then puchased by Chase in 1931. Now, to meet a Chicago law, JP Morgan-Chase traced their history and found that in the antebellum South, banks that now are owned by JPMorgan-Chase allowed slaves as collateral and even accepted took ownership of some people when the borrowers defaulted.

"Citizens Bank and Canal Bank are the two lenders that were identified. They are now closed, but were linked to Bank One, which JP Morgan bought last year. About 13,000 slaves were used as loan collateral between 1831 and 1865" "Because of defaults by plantation owners, Citizens and Canal ended up owning about 1,250 slaves. "

Because of this finding, the bank issued an apology and started a scholarship program for African-Americans from Louisiana.

"JP Morgan officials said the bank undertook the study after Chicago passed an ordinance in 2003 requiring companies that do business with the city to research their history to determine any links to slavery. Among the companies that have been required to do such research are banks, insurance companies, bond underwriters and other financial vendors. Jennifer Hoyle of the city's law department said it was the first contractor's filing to disclose specific slavery information under the new ordinance."

Friday, January 21, 2005

David Hutchinson in Bquest provides an interesting look at bank deposits and the economics of the retail banking industry. (Yeah I know, some of you doubt whether bank deposits can be interesting. Well surprisingly enough, they can be!)

For instance on the role of the FDIC

"Perhaps the most fundamental difference between banks and other financial firms is that under deposit insurance, banks issue a class of liabilities for which most balances are fully insured by the U.S. government. The resulting market structure creates several complications for the implementation of internal profitability and duration models. First, deposit insurance separates the deposit investor from the credit risks of the bank, which are assumed by the FDIC. In essence, when a bank issues a deposit it engages in two transactions: it issues a risk-free (government insured) liability to a depositor and it purchases an insurance contract from the FDIC to cover the credit risks associated with the priority position of the deposit claim"

On duration analysis for retail deposits (and probably the core of the paper):

"Much of the difficulty experienced by bankers and bank economists in measuring value and duration results from the use of analytic tools poorly designed for these markets. Standard valuation/duration models...implicitly assume a competitive market in which a shock to current market interest rates impacts only the economic value of the existing assets and liabilities of the institution. Future bank activity is implicitly assumed to be competitively priced (zero net present value), or at a minimum it is assumed that the profitability of future lending and deposit business is unrelated to current levels of interest rates. In this framework, maturing deposits essentially are assumed to fully re-price to competitive market rates. Thus, determining the value and duration of deposits is simply a matter of determining the maturity of the current deposit liabilities and discounting them at competitive market rates before and after an interest rate shock.

However, because demandable deposits can be redeemed at par at any point in time, they effectively mature and are implicitly re-priced continuously. In the traditional valuation framework, the duration and interest rate risk of these deposits is, therefore, zero .... Yet...neither demandable deposits quantities nor rates respond fully to changing market yields, and thus their behavior is inconsistent with the traditional valuation model."

Now this is not ground breaking news so far and there are proprietary software packages available to analyze this duration, but as Hutchinson points out:

"Although more sophisticated, commercially-available value-added and asset/liability models have become more common, most depositories still depend on traditional modeling techniques. Even among those institutions using more sophisticated methods, frequently the models are a "black box" not well understood by the analysts using them. As will be shown, many of the problems encountered by practitioners result from the inappropriate application of traditional valuation and duration tools that were built for highly competitive markets"

All in all the article is well worth your time and a virtual must for any Money and Banking or Financial Instititutions student/teacher!

In the interest of full disclosure, I am on the editorial board for this journal, but did not review this article for publication nor have any input into the decsion process. Nor for the choice of website format ;)

Thursday, January 20, 2005

There are videos from various conference sessions (from Both FMA and Emerging Markets Conference series) as well as a series of articles on how to improve your presentations at conferences.

I am biased as I am an Associate Editor (trust me I do virtually nothing), but I think the "journal" is one of the most underrated sites there is. You will love it. Betty Simkins and crew do an excellent excellent job!

I am sure I will have more on individual posts in the weeks ahead from the FMA Online site, but for now just enjoy the whole thing!

Over the past 20 years or so state pension funds have come to play an ever more active role in the stock market. For instance, most of us have heard of Calpers which is the California Public employee Retirement System. Not only do these state funds control Billions of dollars, they are also very active monitors. (For instance: removing NYSE president Richard Grasso.)

Monitoring firms by shareholders is a very good thing. We need it to keep shareholder-manager conflicts low. However, when this monitoring becomes more political than economic, there are problems. We have replaced one agency cost problem (shareholder and firm managers) with another (shareholders and fund managers).

"Gov. Arnold Schwarzenegger last week proposed shifting California's pensions for state workers from a massive plan guaranteed by taxpayers to individual 401(k)s controlled by the workers themselves. It's a great idea, not just because it would save taxpayers billions but because it would keep the politicians and union activists who currently run the state's pension funds from improperly meddling in corporate boardrooms."

The crux of the article lies in this paragraph:

"Why do they want to meddle? Because they can. Although private-sector fund managers focus on picking lucrative investments  because that's how they get paid  public fund trustees have different incentives. Sure, they want funds to perform well. But if they don't, they know that taxpayers will make up the shortfall. So they're free to pursue political objectives."

"When union advocates and politicians dependent on unions serve as trustees of public pension funds, they have an irreducible conflict of interest: For them, the union workers they represent always come first, rather than the success of the corporations in which they invest."

MMM, sounds a great deal like a changing nexus of contracts. My students laugh at me for bringing that up so much, but I am convinced that the Nexus is really the most important thing they take out of upper level finance classes. People are REMMs and as contracts (or power in this case) change, so too do the problems facing the nexus (shareholders).

Something to think about as we move forward with social security reform.

CFO.com is truly a great site. It is the online version of CFO magazine and has several great newsletters (which are free I might add :) ) . In fact one of their free newsletters is what has spurred this post.

The site has a list of the 100 most popular finance articles from 2004. I won't give away the top stories, but I will say that there are many very good articles on everything from what it takes to be CFO, to the importance of spreadsheets, and the impact of Sarbanes-Oxley.

Monday, January 17, 2005

Conners lays out why the firm changed its financial reporting, why it both paid a large one time dividend and initiated a buyback plan, and why the firm now uses restricted shares instead of stock options. HIGHLY RECOMMENDED!

A few highlights:

"...we decided against a huge buyback....Our analysis also showed that if we had committed ourselves to a $60 billion share buyback, we could have ended up purchasing 5 to 8 percent of our stock every day that the Nasdaq allows us to buy our own shares for the next three years, and some of that inevitably would have been uneconomic. So we decided to take that $60 billion and use roughly half of it for a special onetime dividend, with the rest committed to a multiyear buyback"

On a question as to whether tech firms will begin to use more leverage:

"For start-ups, the last thing in the world a company like Google is worried about right now is whether or not it should have debt....I don't see why the Wall Street analysis of midsize and large tech companies would be different from that of companies in other industries five or ten years from now. So if the market starts to measure technology in terms of returns on equity, capital, and assets, you will probably see more financial engineering of technology companies to bring them in line with companies in other industries."

Conners also discusses the reporting change (Microsoft now reports financials for each of 7 business units) and the benefits that have accrued from the change.

"One of the most positive outcomes is the transparency the reorganization created"

"The P&L focus also forced some improvements in resource allocation"

"It was surprising how many people within the company didn't really understand how intensely analysts, investors, and the press would follow each of these seven businesses."

"It has allowed us to push much harder on performance "

On Sarbanes-Oxley:

"Of course, there are negatives in Sarbanes-Oxley. For example, there isn't much guidance on what is material for public-company financial statementsnot in the legislation itself or in the regulations or rules yetnor is there any case law defining this. There are far too many areas where companies could take a reasonable risk with good business judgment but still be subject to litigation.

Yet there are real benefits to Sarbanes-Oxley. In our case, we knew what our key controls were, we knew what our materiality threshold was, we had tight budgeting and close processes and strong internal and external audits, but we didn't document everything in the way that Sarbanes-Oxley legislation requires. So we have done a complete business-process map of every transaction flow that affects the financials. In so doing, we have improved our revenue and procurement processes, and we can use controls to run the company in a more disciplined way. So we have gotten real business value out of all that process documentation."

Microsoft has now gone to granting restricted shares rather than options to its employees. In large part to end the worry about strike prices in a volatile market. His comments on the former plan:

"The options program was originally designed to give employees enough money for retirement or a vacation home or to pay for their kids' educationgoals that usually take 15 or 20 or 25 years to achieve. Yet because of the stock performance, people were making enough money to send 3,000 kids to college or build 30 vacation homes."

"We should ask ourselves what would be a worthy aspiration for the financial security of retired Americans in the years ahead. My answer is that we should establish a process that will produce a substantial annuity for every American at retirement age."

"The problem with the current arrangement is that our contributions are a tax, not savings. So we should begin by agreeing that we are going to require all Americans to save, individually, to provide for their financial security in old age."

"Financial security begins with ownership of real assets; so the money saved each year in this plan would be the property of the person who saved it."

"The money would then be invested in broad-based index funds with an objective of matching the overall rate of return for all investments in the United States"

"Further to the definition of financial security: it means enough money in retirement for all needs - food, clothing, shelter - and including medical needs like prescription drugs. If we could work toward this idea, we could reduce our current dependence on the political process for these necessities."

Thursday, January 13, 2005

I do not know what to say on this story. While I do not know him personally, I have been a fan of much of his work for a while now (indeed, I cited some of his work in my dissertaion). I hope it was all just an honest mistake and that he lands on his feet!

The Houston Chronicle has an interesting look back at the Tech bubble. And lest you think it is all just for historic perspective, remember that many of the students now in finance classes were still in high school and had no interest whatsoever in stocks.

"The Nasdaq is still 58.6 percent off its 2000 high as of Wednesday's close, and the technology and biotechnology corporations that helped create the bubble have either matured into value-oriented companies with realistic profit expectations, or have gone under. By the time the Nasdaq is poised for a new run higher, the entire character of the Nasdaq may have changed."

"The impressive gains in 2003 -- a 25.3 percent rise in the Dow and a 50 percent rise in the Nasdaq-- showed that the market could recover. Still, for many investors, stellar returns may have created an unrealistic picture of a stock market that historically has gained 8 percent to 10 percent a year."

"The final tally: the Dow had fallen 37.8 percent from its high, the S&P 500 lost 49.5 percent, and the tech-heavy and startup-friendly Nasdaq tumbled 77.9 percent."

Just as an aside, while the Houston Chronicle's archive is short (only 7 days free), I consistently find it being my first or second read of the day: well written, easy to navigate, and interesting topics. Keep up the good work HC!

How investment bankers allocate hot IPOs is the focus of this paper by Nimalendran, Ritter, and Zhang. The paper presents evidence of abnormally high trading volume in other (non IPO) stocks PRIOR to the IPO. The authors posit that this trading is a means of buying favor with the investment banker so as to be allocated more shares in the coming IPO.

Slightly longer version:

The idea that investment bankers allocate hot IPOs is not new. Not only in academia (Ritter and Loughran 2002 and other papers) but also from the SEC settlements:

"For example, the January 22, 2002 Securities and Exchange Commission (SEC) settlement with Credit Suisse First Boston(CSFB) states that CSFB allocated hot IPOs to some clients and in return received commissions of up to 65% of the profits (money left on the table). The clients kicked back part of their profits by paying unusually high commissions on stock trading that in some cases had no other economic purpose. For instance,the usual commission for institutional investors is at most 6¢ per share, but CSFB's clients paid as high as $3.00 per share in commissions for block trades executed by CSFB brokers."

The current paper looks for more widespread evidence of this buying favorite status. As the SEC-CSFB settlement shows one way to buy favorite status is by paying high commission rates. The authors speculate that another way to buy into a hot IPOS is by trading frequently, and especially trading frequently in the time period immediately before the IPOs (i.e. when the trading will be fresh on the Investment Banker's mind).

"there should be a positive relation between the amount of money left on the table by IPOs and the trading volume of liquid stocks around the IPO dates."

Why liquid stocks? The short answer is because the transaction costs (other than commissions) associated with trading these shares is lower. (Note: I am not convinced of this as a reason. I think it may be easier to funnel money to investment banking firms in less active stocks--see below.)

Highlights:

The sample has nearly 3500 IPOs from 1993 to 2001.

The authors examine "the top 50 stocks for each trading day based on the rank of a stock's average trading volume for the past 20 trading days. We exclude stocks with high volatility or
a price of below five dollars."

"Because of changes in IPO practices, we partition our sample period into three sub-periods: the pre-Internet bubble period (1993-1998), the Internet bubble period (1999 -2000), and the post-Internet bubble period (2001)."

The conclusion?

"For all three subperiods, each $1 billion left on the table during the six trading days beginning on day t generates abnormal volume in the 50 liquid stocks of between 2.7% and 4.0% on day t, although only during the Internet bubble period is this point estimate reliably different from zero."

This abnormal trading would lead to increased commissions:

"The commissions generated from the increase in the trading volume are economically important. During the internet bubble period, for a six-day window with only average IPOactivities, our point estimate suggests that IPO-related trading would cause an increase of 2% in the trading volume of the 50 liquid stocks, and would result in an additional $656,410 perday in commissions if we assume a 10¢ per share commission...."

I was sort of surprised by the small size of the abnormal trading. So too apparently were the authors who address this point by reminding readers that this is a lower bound for several reasons. These reasons include: there may be shifting of trades (eg. a trade that would have been executed on an ECN is traded through one of the underwriting firms), actual commission rates may change, and the firms may also trade less liquid stocks (where I would add there is presumably more ability to funnel money to the firm (ex. higher spreads).

In spite of the rather small findings, this is a really interesting (and important) paper. In fact it is one of those papers that made me sit up and take notice! You will want to read it!

Tuesday, January 11, 2005

When Eric Briys says something, I listen. Not only is he the author of several books on derivatives and one on International Finance (The Fisherman and the Rhinoceros), he also the person who introduced me to blogging. If not enough, he also runs Cyberlibris which is really cool. It is, as they say "the first digital library in Europe." And he also is the main contributor to Cyberlibris Blog.

So when I saw his blog entry today that says there is something better than GoogleScholar, I took notice. Only last week I had sung the praises of Googlescholar, so it was with some apprehension that I clicked on the entry. And lo and behold, the new and improved search engine is a Penn State product! And not only that a Smeal College product! Given that is where my PHD is from, I was excited. Very excited. (ok, so I live a sheltered life).

Check it out. Smealsearch. I have played around with it some (I'll admit not a great deal as my laptop's batteries are about shot) and it looks great. I am not sure if it is fully indexed yet or not. I actually hope not as I could not find a few of my papers nor could I easily find St. Bonaventure, but that said there is NO DOUBT that it will help academic research.

You can search to see what papers reference an author, or you can search for actual papers, or even business schools. It should be a very useful tool!

A reader reminded me last week that the newsletter used to have more stories that everyone could use and not just about academic finance, so I sort of went looking for a few stories that fit the bill. And this one is an excellent one from SmartMoney.

This is a no brainer. I really think everyone should do it. I do not care if in stocks, bonds, both, or in derivatives and treasuries. Saving more regularly is good advice and we are all too busy to do it unless it is done more or less automatically (either by habit, or by an automatic investment plan).

"Whatever the reason, poor savings habits are hardly a recipe for financial security. So why not start off the New Year with a resolution to buck the trend? The easiest way to do that is to sign up for an Automatic Investment Plan (AIP) with your favorite mutual fund company. With these plans, you arrange to have automatic withdrawals taken from your checking or savings account and invested into your mutual fund or funds of choice.

Many fund families will even sweeten the pot by lowering their traditional minimum investment requirements, making this a great way for young investors to get started"

I could not agree more. Automatic plans are the way to go. You do not think about it, and if you do not think about it, you will not miss it! And while it is boring, boring is often good when it comes to investments.

So put aside as much as you can now, and then aim to raise it every year and whenever you get a raise.

"While the 8-K has been around for years, often languishing in the backwater of regulatory filings, big changes put into effect in late last August now require companies to report a greater variety of developments

In addition to the beefed-up role of the 8-K, the commission has made it clear that it will no longer tolerate foggy, obtuse or incomplete information about pay at the top, as well as boardroom relationships. To make its point, the SEC recently fired off cease-and-desist orders to two iconic U.S. companies -- Walt Disney and General Electric Co.

Two weeks ago, Disney was cited by the SEC for not disclosing the fact that three directors' children "were employed by Disney" from 1999 to 2001, among other items. And in late September, the SEC argued that GE's handling of former Chairman Jack Welch retirement benefits in filings with SEC "failed to fully and accurately disclose the 'facilities and services' Welch would receive in retirement."

The next question is "does this increased disclosure affect behavior?" My guess is that it will and CEOs will receive fewer of these benefits. Transparency usually has that effect. A non finance example? Many (not all) food manufacturers are now taking the trans-fat out of foods after it was required that they report on the types of fat in the food.

The North and South Used vastly different ways of financing their war efforts. For instance the North borrowed heavily and raised taxes at the Federal Level. The South, on the other hand, for the early years of the war was quite haphazard in their financing methods and relied quite heavily on printing money (i.e. "Inflation financing"). Why? There are many reasons, but Razaghian suggests that the reluctance of the South to create a powerful central government.

Some of the high points:

"...the difference in their strategies presents a puzzle. Were confederate decision-makers irrational? Did they expect that the war would end quickly?
Were they fruitlessly anticipating England's interference? Was the Confederacy constrained in their financial choices because of a smaller resource base?

I argue that the key to understanding the Confederacy's financial policies is to take into account the political incentives underpinning their financial strategy as well as the endogenous relationship between financial choices and the success or failure of military engagements. Southerners' long-standing defense of states' rights and slavery motivated the initial set of financial policies."

The Civil War obviously changed the shape of the US government as well:

"...the weak status of the American state was significantly altered when the Civil War
unleashed the expansion of the central state. One of the crucial aspects of central state expansion was the significant increase in the capacity of state finance. In fact, Bensel argued that "the only sector to feel the full force of central state authority was the financial system." This expansion of state capacity was embodied in three policies: replacement of the gold standard with paper currency, creation of a national banking system that nationalized the currency, and the placement of the national debt with finance capitalists."

Inflation in the Confederacy was rampant after the summer/fall of 1863:

"...between 1863 and early 1865, the price of wheat increased by almost 1,700%, bacon by 2,500%, and flour by almost 2,800%. By the end of the war, prices for shoes rose to $600 per pair in some counties and a simple wool overcoat could cost as much as $1,500.34 In fact, the volume of currency was so large that some printers had to use old and used paper to satisfy the demands of the Treasury. Some printers even supplemented their paper supply with lining papers and wallpapers to continue printing notes."

"The first significant decline in the Confederacy's currency seems to have taken place in the Summer of 1863, with a threefold depreciation from $5 in March to $14 in October for one gold dollar; at no other point did the value of the currency decline at this rate in the span of seven months."

"As the money supply flooded the economy, capital markets dried up. In addition, militarysetbacks, especially the news of Gettysburg and Vicksburg in early July 1863, led to a sharp decline in Erlanger bonds. By the fall of 1863 McRae (the Confederate agent abroad) had decided that it would be impossible to raise a large amount of money on good terms unless the Confederates began to have better success in war."

A very interesting history! I know I learned quite a bit of both history and finance.

Friday, January 07, 2005

In class discussions of financial distress all too often center on higher borowing costs. It is important to note that financial distress can also increase operating costs (who would want to work for a firm that may go out of business?), and reduce revenues.

"Nancy Holtzman, executive director of the Association of Corporate Travel Executives, says many corporate travel planners are worried about the airline folding. "The ongoing state of bankruptcy and the carrier's uncertain future would have any travel manager considering a back-up plan for travelers who rely on USAir's system," said Holtzman, whose association has 2,500 members. "Most of our members have already planned for that contingency.""

A perfect example of reduced revenues stemming from excessive leverage.

I got an email earlier this week from Forbes and was interviewed for the following article. I am pretty psyched. Even though the article is pretty short, but whenever you get mentioned with people from Chicago and Wharton things can not be all that bad ;). (and of course with people like Rodney Paul and Andy Weinbach, but since I know them they count twice!)

BTW Just in case you would like more on this topic, here is a part of the actual email where I replied to some of Forbes' questions:

Forbes: 1) I was hoping you could provide me with your insight on the efficiency- or inefficiency - of the sports gambling market. Essentially, what do you believe is the cause - or causes - of the inefficiencies that exist in this market?

Jim: Overall I would say the market is efficient. However, efficiency does not imply perfection. (that is the same trap that people fall into when it comes to financial markets---efficiency does not imply perfection.)

Why is it so? Because many people are trying to make money. If something gets out of line, then people will trade (in this case bet) to push thing back "in line". As new information becomes available (say someone is hurt), that immediately gets incorporated into the "lines" just like new information gets incorporated into the stock price through trading.

So why are betting markets not perfect? (or in other words where are there inefficiencies).

[While not discounting behavioral reasons, a] big reason is transaction costs and bet limits. For example, Rodney Paul and Andrew Weinbach have several papers that suggest overall the betting market is good, but in small pockets of the market there are predictable inefficiencies. These pockets tend to be caused when large players (who arguably would be more rational and be trading on real information and not feelings etc) are limited in their ability to push the market back to where it belongs. This line of reasoning would suggest that the betting lines on a a Div II college football game would be less efficient than betting on a super bowl game. Again this is much like stock market where the market for a DOW stock tends to be more efficient than that for a penny stock.

Now within these pockets of inefficiency, there are some interesting biases [that are consistent with behavioral explanations]. For instance Paul and Weinbach have shown that the bettors tend to put too much emphasis on scoring (that is they bet the "over" too often). There may be behavioral reasons for this (people like scoring).

"For example, in gambling on football, large favorites (those favored by a touchdown or more) tend to be "over-bet" (Paul and Weinbach, 2003).

Another recognized anomaly in football betting markets involves betting on the total number of points scored in a game. In this situation it has been shown that bettors "over-bet" the "over" for those games where the over/under is 47.5 or greater (Paul and Weinbach, 2002). "

Why? It might be that people get utility from more than just the money they win. So by betting the favorite, they can then brag that they picked the right team (even though the right team may not have covered.) Or they might like scoring?

While these cases of inefficiency are important and fascinating, I think it is important to remember that they are the exception to the rule. Overall, it does appear that the gambling markets are quite efficient.

As an aside, I would add, that the behavior of betting markets can yield some valuable insights into the behavior of financial markets. There are more similarities than many people would suspect.

Forbes: Do you believe it difficult to come out ahead in the NFL gambling market? If so, why?

Jim: Yes. [see answer above] The Betting market tends to be pretty efficient. There are many very smart people all with approximately the same information. All have a vested interest to do well. That is not to say it can not happen, but just like the stock market, the vast majority of people are not going to come out ahead.

Forbes: I was hoping you could provide some tips for those who intend to gamble during the upcoming football playoffs.

Jim: Not to bet anything they can not afford to lose is by far my biggest piece of advice! :) But from the evidence, don't get too caught up with the favorites and remember that often times games are lower scoring than expected.

Speaking of Nobel prize winners, over at the Becker-Posner blog, the discussion is on the tsunami. More precisely on catastrophic events that are unlikely but do occur. "The fact that a catastrophe is very unlikely to occur is not a rational justification for ignoring the risk of its occurrence." The reasons why these risks are often ignored are particular worthwhile!

Economist Brad DeLong shows once again that when he writes on finance or economics he is very interesting! In this piece he discusses the long run equity risk premium and the likelihood of stocks out performing other investments. He concludes that a recent Economist article based on the work of Dimson, Marsh, and Staunton is possibly too pessimistic. Readers of my blog (may remember D,M,&S's work from back in July. I agree with DeLong, but still maintain that DM&S hit the nail on the head when they bring up the point that equities will probably not return as much in the future as they have in the past.

KimSnider comments on a Baron's article which is about a paper by Bergstresser, Chalmers, and Tufano that struggles to find a reason for investors to buy mutual funds though a broker. While I disagree with Sniders' dislike of mutual funds as a whole, I totally agree with the her on her stance against buying load funds.

Marketweek (or should I say MARKETWEEK ;)) points out that China is "caught between a rock and a hard place" with respect to devaluing its currency. If I were in charge? I would let the yuan float. Probably in steps with a series of devaluations coming first, but I would like to think I would do something and do it soon. The sooner, the better. Prolonging it will only make it worse.

Fed Governor Donald Kohn gave an interesting speech today on how the Fed reacts to crises. Some of the high points:

In crises, good information is a valuable (and rare) asset

"As I am sure we will hear time and again today, knowledge--reliable information--is essential to managing risks. In a financial crisis, however, information inevitably will be highly imperfect. The very nature of a crisis means that the ratio of the unknown and unknowable will be especially large relative to the known, and this, in turn, can influence how policymakers judge risks, costs, and benefits."

It is better to prevent a crisis than to respond to it.

"I want to emphasize at the outset that the far-preferable approach to financial stability is to reduce the odds on such crises developing at all. To this end, central banks seek to foster macroeconomic stability, encourage sound risk-taking practices by financial market participants, enhance market discipline, and promote sound and efficient payment and settlement systems. In this arena, an ounce of prevention is worth many pounds of cure"

However, Fed Policy can cut both ways.

"...some policy responses to a crisis can themselves have important costs that need to be balanced against their possible benefits....intervening in the market process can create moral hazard and weaken market discipline....Weaker market discipline distorts resource allocation and can sow the seeds of a future crisis."

"Approaches that work through the entire market rather than through individual firms run a lower probability of distorting risk-taking. Thus, a first resort to staving off adverse economic effects is to use open market operations to make sure aggregate liquidity is adequate."

"Second, we must determine whether the stance of monetary policy has to be adjusted to counteract the effects on the economy of tighter credit supplies and other consequences of financial instability."

Why the Fed?

"Whatever the origin of the crisis, the Federal Reserve has usually found itself near the center of the efforts to assess and manage the risks. To be sure, we have some authorities and powers that other agencies do not. But in addition, we bring a unique perspective combining macro- and microeconomic elements that should help us assess the likelihood of disruptions and weigh the consequences of various forms of intervention. Because of our responsibility for price and economic stability, we have expertise on the entire financial system and its interaction with the economy. Central banks need to understand--to the limited extent anyone can--how markets work and how they are likely to respond to a particular stimulus. Our role in operating and overseeing payment systems gives us a window into a key possible avenue for contagion in a crisis."

on the recent past:

"In the past few years, the financial markets have come through an extraordinarily stressful period, but one that was not marked by the sort of financial-sector distress that accompanied and intensified the economic problems in many previous such episodes. I attribute that relatively good record, in no small part, to greater diversification of risk, to the growing sophistication of risk management techniques being applied at more and more institutions, and to stronger capital positions going into the period of stress."

Remember this is his own opinion and not Fed policy!

"No institution can be "too big to fail. Handling the failure of a large, complex organization--imposing the costs of failure on management, shareholders, and uninsured creditors while minimizing the effects on the wider economy--will certainly be complicated. But we cannot allow the public interest in containing moral hazard to be held hostage to complexity."

"We propose a simple new approach to equity portfolio optimization based on firm
characteristics. We parameterize the weight invested in each stock as a function of the firm's characteristics, with the implicit assumption that these characteristics fully capture all aspects of the joint distribution of returns that are relevant for forming optimal portfolios. We then estimate the coefficients of the portfolio policy by maximizing the utility that would have been obtained by the investor from implementing the policy over the sample period."

In English? They develop a model that can be used to find optimal portfolio weights of assets based on the asset's characteristics. Moreover, the model is flexible enough to be altered to fit a variety of utility functions.

While some of us may question how "simple" the method is (the authors repeatedly claim it is simple), the paper really is much more practically applicable than many of the quantitative models based on the Markowitz optimal portfolio approach and it tends to based on firm characteristics (such as size and book to value ratios) that are readily available.

Again in the authors' words:

The most important aspect of our parameterization is that the coefficients are constant across assets and through time. Constant coefficients across assets implies that the portfolio policy only cares about the characteristics of the stocks, not about the stocks themselves. The implicit assumption is that the characteristics fully capture all aspects of the joint distribution of returns that are relevant for forming optimal portfolios. Constant coefficients through time means that the coefficients that maximize the investor's conditional expected utility at a given date are the same for all dates and therefore also maximize the investor's unconditional expected utility.

In the later sections of the paper, the authors relax many of the restrictive assumptions they used initially (for example they allow for the possibility of coefficients changing with the economy) and even create a real portfolio based on their model. Their model portfolio dramatically outperforms other market models.

The optimal portfolio has a volatility slightly larger than that of the market portfolio, 19% versus 16%, but has an average return of 24.4% as opposed to 12.0%. This translates into a certainty equivalent gain of 10%.

So what does their so-called optimal portfolio look like? Given what we know about anomalies and apparent inefficiencies (for example: value anomaly and size anomaly and momentum investing), it should not be surprising that the optimal portfolio had more small stocks and more value stocks.

"The market portfolio has a bias towards very large firms (due to value weighting) and firms with below average book-to-market ratios (growth), while it is neutral with respect to momentum. In contrast, the optimized portfolio has a slight bias toward small firms and much stronger biases toward high book-to-market ratio (value) firms and past winners."

No we are not talking what you leave at restaurants. Tipping here is the idea of giving stock tips to select customers prior releasing the recommendation to all of their clients. It is important to realize that tipping is not illegal. While some brokerage firms have rules against it, tipping in and of itself is not illegal.

Irvine, Lipson, and Puckett use a "proprietary database" to examine unusual trading activity around initial recommendations. The authors find:

a significant increase in institutional trading and abnormal buying beginning about five days prior to the public release of analysts' initial reports(initiations). We confirm that institutions buying in advance of the initiation earn abnormal profits."

It is possible that this unusual activity is caused by the institutions forecasting when the analysts would issue recommendations. The authors attempt to address this and give fairly convincing proof that it is not the case. Their most convincing evidence is that this unusual trading activity begins at the same time the analysts would have finished the report and passed it on for internal review prior to public disclosure.

While not totally unexpected, the finding that certain institutional investors trade PRIOR to initial buy or strong recommendations is not good from a "level playing field" perspective. But it does lead to the important question:

Is tipping good or bad?

It is not as easy of question as one might originally suppose. For instance, the authors make an excellent point in their discussion:

"...The trading profits that tipping provides to large institutions are likely to be one of the services large institutions expect from analysts' firms. If tipping were precluded, institutions would be less willing to pay for sell-side research and, consequently, the amount of price relevant sell-side research would be reduced. For this reason, the social welfare implications of tipping are unclear...."

That said, I would still like to see a more level field and more transparency.

Definitely interesting and well worth a read! I still have some reservations about whether this is actual total proof of tipping. It could still be that the institutions are not just seeing the same things that lead the brokerage to initiate coverage, but am almost convinced. ;)

Tuesday, January 04, 2005

What a great way to kick off the new year! This one definitely qualifies as I^3 (interesting, informative, and important)

Super short version:

Han and Wang have an interesting paper that examines the “impact of institutional investment constraints.” Their finding (that these constraints play an important role in the pricing of securities), gives us a much better insight into both institutional behavior as well as momentum investing.

Slightly longer version:

We have seen repeatedly now that things that limit arbitrage (for instance short sale constraints, high transaction costs etc.), limit market efficiency. This paper by Han and Wang is no expection. However, it looks at self-imposed contraints.

Lakonishok, Shleifer and Vishny (1997) ; Chan, Chen, and Lakonishok (2002); and Cohen, Gompers and Voluteenaho (2003) have all shown that institutional investors tend to not take positions significantly different from their benchmark portfolios. This may be because of a reluctance to accept non-systematic risk or incentives induced by contracting and/or agency costs.

In this paper Han and Wang investigate whether this behavior has consequences on market pricing and market efficiency. (In other words, they are testing whether these constraints—which are largely self-imposed—lead to predictable differences in the financial markets.) And lo and behold, the authors find that the constraints do matter!

“Using quarterly data on institutional equity holding between 1980 and 2001, we find that institution investors appear to be constrained from buying stocks that they already overweight and selling stocks they underweight. Such demand distortion may lead to price inefficiency for the stocks affected by these institutional investment constraints and generate cross-sectional return predictability as the mispricings get corrected.”

In simpler terms: if institutions already have a large position in a stock (i.e. overweighted), they are less likely to buy more, even if the stock price is going up. And vice verse—they are less likely to sell shares that they already underweight, even if the stock experiences more bad news.

Why is this important? Several reasons:

1. It shows again that where there are imperfections (even self imposed) that markets are less than perfectly efficient.
2. It shows that self-imposed constraints can be quite binding and that they do lead to predictable differences in the asset market.
3. It gives us a much better understanding of how momentum investing can be allowed to continue. In the author’s words:

“...we find that the momentum strategy which invests in the winner stocks that the institutions overweight and the loser stocks that institutions underweight is significantly more profitable than the simple momentum strategy that invests in all winners and losers. By contrast, buying the winners that institutions underweight and selling the losers that institutions overweight do not generate significant profits.”

Wow! You may want to reread that last quote! If true (and they have pretty much convinced me), they have given us the best proof yet as to why some researchers have been able to find abnormal profits from momentum investing.

Given these far reaching implications the time that Han and Wang spend looking at various alternative explanations is well spent. They find these other explanations all wanting in some important area. Thus, it appears that the constraint hypothesis is the best explanation.

Not sure if you have seen this or not, but Google has added a pretty useful site to search only for academic articles It also gives an approximate number of papers that cite the article.

There are better academic sites, but they are generally rather expensive and often only available through universities. Google's new site should make research at small colleges and universities much easier :) and you can do it for free and without passwords :)

Saturday, January 01, 2005

Before getting back to work this week, I wanted to wish you all a very happy, healthy, and prosperous 2005!

Here is past list of financial resolutions that I suggested would be fitting to almost all:

1. I will take an honest account of my spending habits, my net worth, and my investment goals.
2. I will let the power of compounding work for me and not against me by investing more and by paying off high interest debt (especially credit card debt which I will entirely pay off during as soon as possible).
3. I will set up a savings and investment plan and stick to it (hint: the best way to do this is with an automatic withdrawal program).
4. I will spend less than I want to and save more than I think I need to.
5. I will remember that there is “no free lunch.” If something looks too good to be true, it probably is.
6. I will diversify my investments to reduce risk.
7. I will not get caught up in daily market volatility but will keep my eyes on my long term goals.
8. I will remember that there is more to life than money.
9. I will invest not only in stocks and bonds but also in myself, my family, and my community.
10. I will remember that money is never worth losing one’s family, one’s friends, or one’s health over.
11. I will remember that amoung the most valuable assets anyone can have are a family and friends, a good reputation, good health, and a clean conscience.
11. I will be generous with my time and money.
12. I will be thankful for what I have and not jealous of what others have.